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Sunday, October 26, 2014

26/10/2014: Mind the ECB 'Stress Tests' Gap

The pain of European economy's Japanification is going to be proportionate to the cheering of the ECB 'stress tests' results.

The real problem faced by European economy is that of the depressed domestic demand (investment and consumption). This problem is fuelled by:
1) declining real incomes of those working,
2) continued sky-high numbers of those who are not working (unemployed, discouraged and never-once-employed workers left out in the cold),
3) growing unease amongst older workers about the state of their pensions,
4) rising burden of the state (including state debts),
5) growing pressure of redistribution of income from households and SMEs to politically favoured white elephant projects (e.g. renewables subsidies, large infrastructure spending, farm supports, regional integration etc),
6) un-abating waste at the EU and national levels anchored to corporatist politics selectively rewarding specific interest groups interests at the expense of entrepreneurs, younger workers, ordinary households and domestic firms, and
7) demographic collapse spreading across the continent as populations age and children remain dependent on ever older parents to support their education and transitioning into joblessness.

This real problem is driving down domestic demand, and with it depressing economy, but also spreading rot across the banks balance sheets.

And yet, despite the obvious and ever-deepening macroeconomic crisis of depressed demand, the ECB stress tests released today provide no insight into what can happen to the banks balance sheets should Japanification set in. Worse, the entire exercise of 'stress tests' is once again not much more than a PR stunt dreamed up by the folks who are 'would be' chief economists for the sell-side equity research.

This identified stressed shortfalls estimated at between €82 billion and €176 billion (4% benchmark capital ratio) and €509 billion to €767 billion (7% capital ratio) based on book capital. Take the average to compare to ECB results: ca EUR295-470 billion. "The market capital shortfall estimates indicate a capital shortfall of €230 billion (4% benchmark capital ratio) or €620 billion (7% capital ratio) for the 41 publicly listed banks". Take the average to compare to ECB results: EUR425 billion.

Worse, "estimates of SRISK or the capital shortfall in a systemic financial crisis (40% market decline over a six-month period) is €579 billion; 41% is due to downside correlation with the market, while 59% is due to the leverage of these institutions." So compare to 20% decline under ECB tests (across property assets, 30% decline) and get roughly half of the above figure at EUR290 billion.

Ugly? Try next: "Capital shortfall estimates when writing down their net non-performing loan portfolios range from €232 billion (using the C Tier 1 ratio and an 8% threshold as in the AQR) and €435 billion (using the tangible equity/tangible assets ratio and a 4% threshold)." Again, average these out at EUR330 billion or so.

And get this: "There is a high rank correlation between the shortfalls based on book and market capital ratio measures [but] no significant correlation between shortfalls calculated using regulatory (i.e. risk-weighted asset-based) capital ratios and shortfalls calculated under market or book capital ratios… this highlights how flawed risk-weighted asset-based measures can be."

Take the conclusion in with a deep breath: "Cross-country variation in our capital shortfall estimates indicate that:

French banks are leading each book and market capital shortfall measure, both in absolute euro amounts and relative to national GDP. The capital shortfall ranges from €31 billion (using the equity/asset ratio and a 4% threshold) to €285 billion (using the tangible equity/tangible asset ratio and a 7% threshold). The SRISK stress scenario suggests a shortfall of €222 billion, which corresponds to almost 13% of the country’s GDP.

German banks are close seconds, although they benefit from a stronger domestic economy with a higher GDP and a greater capacity for public backstops.

Spanish and Italian banks appear to have large capital shortfalls when non-performing assets are fully written down. Both countries account for about a third of the total shortfall after write-downs. Market-based measures such as SRISK amount to about 6.5%–7.6% of the GDP of both countries."

So a close common value for estimated shortfalls, comparable to the ECB tests is around EUR290 billion for 41 listed banks (not 150 tested by EBA/ECB).

This is plain mad not only because it is more than 10 times the number averaged out above, but also because the same ECB review found that some EUR136 billion of loans held by the banks as assets should be classed as non-performing. That is an 18 percent hike in one sweeping year. 85% of banks tested had to revise up their bad loans exposures. And this implies that EUR47.5 billion worth of losses is required to bring these 'assets' in line with their true values.

These losses will have to be covered from either more tightening of existent loans costs or via capital raising or by shrinking returns on equity or all of the above. And these losses are at the lower (as noted by independent analysts) end of the range. And these losses are going to impact future capital access by the banks too, as who on earth would want to stake a house on investing in sick banks hiding the true extent of their losses to the tune of 18 percent?!

All in, Euro area banks now have a hole of EUR879 billion in non-performing loans, facing losses of some EUR300 billion, plus. Based on already stretched (by extend-and-pretend measures adopted to-date) loss rate on non-performing assets. Oh, dear…

As of the end of 2013, per ECB own assessment, some 1/5 of all major banks were in the position of facing high risk of going bust. Forward nine months into this year - what has changed? Nothing, save for the following factors:

ECB funding became temporarily cheaper (rates down), but LTROs are being replace by higher priced TLTROs and this means cost of funding going slightly up;

Assets valuations have improved on massive monetary stimuli. These being gradually reduced (outside the euro area) is going to depress carry trades that have been helping asset prices boom. Asset values might not fall, but realising these values in the markets forward and counting on their further significant appreciation would be equivalent to taking serious risks.

Real economic conditions have deteriorated. Which is far from being trivial, as in the long run, asset values and availability and cost of funding should start reflecting this reality. Once they start, there'll be pain on balance sheets.

What are the safety cushions post-ECB tests? Ugh, rather thin. Of 130 banks tested by the ECB, 25 failed, 31 had core capital ratio below 10% - the safety threshold accepted in the markets. 28 more banks were within a 10-11 percent range. Thus, 84 out of 130 banks tested were either in an ICU or on ventilators.

Looking back at the main findings from January 2014 paper by Viral Acharya and Sascha Steffen, what is striking is the position of the German and French banks. ECB found virtually no problems in both countries banking systems (see Table below):

Table: Banks that failed ECB tests

Look at geographic distribution of losses under stressed scenario:

Setting aside the proverbial 'periphery' (and Slovenia) there are virtually no problems in the stress case across the national banking system anywhere, save for Belgium, the Netherlands, and Luxembourg. Even Italian system is within 1 percentage point of the median losses. You have to be laughing, right?

And the above only holds for 57% of all assets of the tested banks. That's right, the AQR exercise did not cover all assets held by the 130 banks tested.

Meanwhile, macroeconomic risks factored in are rapidly becoming not stringent enough. The ECB tests were based on EU Commission forecasts from Q1 2014. Since then, the forecasts have seen consistent downward revisions. Instead of focusing on the risk of deflationary recession and stagnation (Japanification), the risks tested were based on bond markets stress, plus recession.

There is virtually no material deterioration in ECB assessment results for German banks compared to previous tests. How? We can only scratch our heads. In the last 2 years, German economy has gone from moderate growth to slow growth and is heading into stagnant growth.

Emerging markets risks exposures were non-existent in the view of the ECB tests, except via higher interest rates impact spillover from the US (assumed by the ECB). Neither were the risks arising from the global slowdown in trade flows. So here's a kicker, if rates are higher and there is a global slowdown, impact on banks balance sheets will be most likely lower than if rates are low (and with them lending margins), but there is a secular long term growth crisis in the euro area itself. Second order effects will be smaller than first order effects.

All in, the 'stringent' tests carried by EBA and ECB took 150 banks and banks subsidiaries and found that 25 of these were short of EUR24.6 billion in capital: 16.7% of banks failed, average capital requirement per failed bank EUR984 million, average capital required per all banks tested: EUR164 million. Contrast this with 2011 when EBA tested 90 banks, failed 20 of these (failure rate of 22.2% much higher than 16.7% in this round of tests), requiring them to raise EUR26.8 billion in capital which amounts to EUR1.34 billion per failed bank (much higher than ECB stress tests this time around) and EUR298 million per bank tested (much higher than ECB tests). Yet, 2011 tests were labeled a farce by the markets.

Today's tests are no better. If not worse.

Worse because they fail to account for the real risks arising in the Euro area today and worse because they create a false sense of security within the system. Or maybe they do not. In which case the entire exercise is a PR stunt, with ECB having a different and more descriptive picture of what is really happening in the banking sector. Maybe so… in which case, does the whole charade qualify as market manipulation by the soon-to-be super regulators? Take your pick, either the regulators-to-be are wearing rose-tinted glasses, or they are fixing the market. Neither is a pretty option...

Disclaimer

This blog represents my personal views and is not reflective of the views or opinions held by any company, contractor, client or employer I work for currently or have worked for in the past. These views are not an endorsement to take any action in the markets or of any political position, figures or parties.

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